The Bank of England is happy with banks, and is now worried about the rest of
the financial system

Could the worst of the regulatory onslaught for banks be over at last? It might not seem as such given the way lenders have launched a fightback against the bank levy and the top-up corporation tax in the Chancellor’s emergency Budget, but there are signs that regulators are close to being happy with the position of the industry.

The Bank of England is indicating it is more and more satisfied with the progress banks have made, allowing the Old Lady of Threadneedle Street to start focusing more on other parts of the financial system instead.

Presenting this month’s Financial Stability Report, the Bank’s Governor Mark Carney highlighted risks to the City from sources as varied as the turmoil in Greece, a slowdown in emerging economies, cyber attacks and the UK’s current account deficit.

But amid the possible threats to the financial system, he pointed to British banks as a strong point which can absorb and mitigate instability – a major change from the aftermath of the credit crunch. “These could cause investors to panic, leading to rapid and unexpected flows of funds which could take asset managers by surprise.”

“The risks we have identified should be weighed against the increasing resilience of the banking system, where capital positions have continued to improve in the past six months,” said Mr Carney. “While the resilience of the institutions at the core of the financial system has continued to strengthen, risks are shifting to the markets that connect them, and to the infrastructure that underpins them.”

That means asset managers, insurers, hedge funds, central counterparties where securities are traded and settled – all important parts of the system which have not had as much focus because banks merited so much attention following the crash.

Mark Carney told MPs that some asset managers may have over-estimated liquidity in the bond markets (Credit: Parliament)

Banks are also more confident. In a sense, their increasingly vocal grumbles show this, as they believe that the financial crisis is sufficiently far in the past to give them room to speak up. Lenders could not voice their concerns so publicly if they did not believe they had made good progress implementing new regulations and taken steps to convince officials that the industry is substantially safer than it used to be.

It does not mean the Bank of England is backing off – the biggest lenders still face stress tests this year, for instance, in which they and the regulator simulate the impact of a major slowdown in China and other emerging economies to see how tough the banks really are. It follows a stress test last year which mocked up the impact of a house price crash, and each year for the foreseeable future will see a new test on a different market, to keep the sector on its toes.

But now much of the wave of regulation appears to be calming down, lenders can survey the scene and study the impact on the wider industry. A key complaint is that regulation has resulted in regulatory arbitrage, pushing some activities out of banks and into other sectors, which fails to remove the risks to financial stability.

Anthony Browne, chief of the British Bankers’ Association (BBA), said he has seen some action in this from the Bank of England and the Financial Conduct Authority.

“So one example of that is the payday lenders .The banks are required by legislation only to lend money to people who they know can sustainably repay their debts. The payday lenders were not regulated like that, and in fact a lot of their business models were based on the fact that people couldn’t repay their debts,” Mr Browne said.

“There was a lot of political outrage, demands they become regulated, so they were swept under the Financial Conduct Authority, and are regulated in a more similar way to banks, not lending to people who can't really pay their debts – and 90pc of them go out of business.”

Mr Browne wants this approach to be extended across the board: “Regulation should focus on the activity, like lending, rather than the legal status of the entity that is doing that activity. It should look at the risks associated with the activities, the risk of misconduct, and financial stability as well.”

That has not gone unnoticed by Mr Carney either, who is keen to step up surveillance of bank-style lending by insurers and the investment banks’ trading activities which have moved to hedge funds.

Some of this is due to unintended consequences of regulation, as the authorities pumped up capital requirements for banks, making it harder and more expensive for investment banks to trade securities like bonds. In the past, active trading desks were more able to deal with the fallout from big market shocks – now that buffer has diminished.

The lack of liquidity could pose a risk to investors and asset managers. The Bank of England is studying the possibility, and while it has not yet decided if any action is needed, it could have important ramifications for investors.

A survey of 135 asset managers found potential problems in their assumptions around the availability of liquidity, the Governor said, which is increasingly important as the asset management sector has almost doubled in size in the last decade.

“In aggregate, the expectation of asset managers resident in the UK on the availability in the corporate bond market, for example, to sell securities if there is stress event, is a significant multiple of the underlying turnover in those markets, in other words it is a classic crowded trade. Whereas in the equity market, it is a very small fraction. So there are issues we need to get to the bottom of,” Mr Carney told MPs this week.

“The liquidity arrangements for asset managers were put in place during a different time, when asset managers were not as important as the proportion of assets in financial markets. They were put in place in a time when liquidity in financial markets was ample, in fact it was excessive in pre-crisis times, and they were put in place when there was very little algorithmic trading, and when central bank policy was different.”

That could be a pointer to the possibility of limits on withdrawals from funds in some circumstances. Hedge funds typically include controls such as gating. It limits redemptions to prevent a run on a fund. Meanwhile with side-pocketing, illiquid assets are kept in a separate pot from liquid ones, with commensurate limits on the amount investors can withdraw at any one moment. By contrast, investors are very keen on the weekly or daily liquidity offered by many of the most popular asset managers.

While it might be unpopular with some investors, asset managers are not necessarily opposed to the idea of acting to adjust the mechanisms through which investors buy and sell securities.

“There are a whole host of different things that could be on table – gating is one, side-pocketing is one. Blackrock has floated an idea in the US around funds being able to give lines of credit to each other. We’ve not looked at that, but that is one idea out there,” said Anne Richards, chief investment officer at Aberdeen Asset Management. “Another is that, just as in extremis the Bank of England gives emergency support to banks in certain circumstances, is that something the Bank of England would do to ensure an orderly market? I don’t think there are any answers on any of these yet, it is very early days.”

She also hopes this will start a discussion with investors on the purpose of investment, such as bonds’ and shares’ relationship with the underlying issuer’s investment in real-world activity, which could lead to an increased recognition that it might not always be reasonable to expect instant liquidity in a bond which funds a decades-long piece of investment.

None of this is a done deal. The Bank has launched a lengthy consultation period, a highlight of which will be a major open forum in November, which officials hope will be a large-scale event with representatives from across financial services present to hammer out their arguments on where vulnerabilities lie.

“A number of market participants may over-estimate the liquidity of [long-dated] securities. An example is the big increase in daily liquidity asset managers in emerging market corporate debt,” the Governor said. “That is a very illiquid market at best of times, and extremely illiquid when inevitably you have a turn in interest cycle in United States, and you get a sudden stop of capital flows to emerging markets and all of a sudden it is very difficult to get out of those positions.”

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